1 NABE Annual Meeting: October 13 16, 2012 Bridging the Gap Between Finance and the Real Economy Computational Economics and Big Data: How Technology s Transforming Business Decision Making David K.A. Mordecai Risk Economics, Inc. 1 Copyright 2012 Risk Economics, Inc.
2 Computational conomics An emergent algorithmic paradigm involving distributed social adaptive procedurally rational (learning, search), and inherently Bayesian inference inference Generative social simulation re: carrying capacity and complexity Resource competition, cooperation, and CPRs (common pool resources) competition cooperation and pool resources) e.g. liquidity, credit Sustainability, fragility, stability Neo institutional in nature Hebbian learning, search, and complexity Interactions between heterogeneous, autonomous agents (Neo Keynesian?) Sparsity vs. parsimony 2 Copyright 2012 Risk Economics, Inc.
3 Seminal Trends Pervasive, mobile adaptive social computing and sensing Urbanization Rental/leasing markets Service flows vs. Ownership (asset stocks) Co location and microtransactions Fundamental changes in commerce and finance consumer credit and insurance Payment systems and ecurrency (e.g. Bitcoin) 3 Copyright 2012 Risk Economics, Inc.
4 Emergent Institutional and Market Determinants Monopolistic Competition Supply/Demand elasticities Dominant oligopolies with competitive fringe Market contestability Microstructure Auctions and (real) options imbedded everywhere (ubiquitous, pervasive) Herds, fads, fashions (social contagion and cultural propagation; norms) Curated life experiences, events trajectories CPRs and network externalities Lock in and path dependence (increasing returns) Product liability and warranty (legal, insurance) implications Epidemiology, environmental toxicology i i lt i l Evidentiary (discovery, causation, liability rules, damages, etc.) 4 Copyright 2012 Risk Economics, Inc.
5 Data Science Tools and Methodologies Scalable Bayesian inference (with sparsity) Large vs. small samples Spatio temporal dynamics Unstructured data Crowdsourcing, Machine Learning, Agent Based Models Coordination and mechanism design Experimental economics Activity Recognition Social network analysis (peer effects) Discrete choice and hedonic pricing (e.g. market baskets re: preferences, utilities, elasticities) 5 Copyright 2012 Risk Economics, Inc.
6 Urbanization will result in changing dynamics (e.g. unemployment, crime) Copyright 2011 Risk Economics, Inc Copyright 2012 Risk Economics, Inc.
7 Agent Based Modelling Realistic ground up models of real world strategic interactions, structural shifts, and complex evolving dynamics 7 Copyright 2012 Risk Economics, Inc.
8 Demographics, Sociometrics and Psychometrics matter Actively monitoring consumer behavior, lifestyle choices, and aggregated preferences at the right level of granularity can be predictive of both short and long tailed loss development. 8 Copyright 2012 Risk Economics, Inc.
9 Is there an Analogue for Casualty Underwriting? Source: Deloitte Consulting 9 Copyright 2012 Risk Economics, Inc.
10 Case in Point: Correspondences Between Business Conditions, Unemployment, and Insurance claims 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500 7, /00 04/01 10/01 04/02 10/02 04/03 10/03 04/04 10/04 04/05 10/05 04/06 09/06 03/07 09/07 03/08 09/08 03/09 09/09 03/10 09/10 Graph 1: Initial Claims vs Continuing Claims Recessions Initial Claims Initial Claims 4Wk MA Continuing Claims Cont Claims 4Wk MA Graph 2: Initial Claims (000s) Current Expansion 2001 Expansion 1991 Expansion 1982 Expansion 1975 Expansion 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500 7, Graph 3: Continuing Claims (000s) For example, there are currently unexploited techniques for analyzing statistical relationships between changing unemployment insurance claims relative to workers compensation and disability claims. Source: NBER, ETA and Risk Economics TM calculations 10 Copyright 2012 Risk Economics, Inc.
11 Disability versus Earnings Relative earnings of permanent partial disability claimants as a proportion of earnings of comparison workers in five states What this graph does not tell you is that disability claims increase during periods of high unemployment, i.e. poor business conditions. In other words, disability and workers compensation may be serving as a substitutes or supplements to unemployment insurance. Question: what specific industry and occupational characteristics may be predictive? SOURCE: Robert T. Reville, Leslie I. Boden, Jeffrey E. Biddle, and Christopher Mardesich, An Evaluation of New Mexico Workers' Compensation Permanent Partial Disability and Return to Work, MR 1414 ICJ (Santa Monica, CA: RAND Institute for Civil Justice, 2001) 11 Copyright 2012 Risk Economics, Inc.
12 Socio Informatics: Network Analysis, Data Mining and Text Mining Source: CI Chicago These analytic methods are applicable to many risks: Energy and power and natural resource markets; Social systems and integrated modeling of interactions between natural and social processes; national security topics, e.g. distributed adaptive network control and terrorist networks; supply chain dynamics; biological systems, including pandemics; industrial and macroeconomic structures (trade and capital flows); other geopolitical, socioeconomic, legislative, regulatory, commercial, financial 31 market and policy issues. 12 Copyright 2012 Risk Economics, Inc.
13 Text Mining has Forensic Implications for Tort, Litigation, and Claims Settlement 13 Copyright 2012 Risk Economics, Inc.
14 ` The Shadow Banking System Conceptualized, designed and created by Zoltan Pozsar The Federal Reserve Bank of New York, November, 2009 The Traditional Banking System Ultimate Borrowers Households, Businesses, Governments Assets Bonds Assets Borrowers Commercial Banks Dollar Deposits The Traditional Banking System ("Originate-to-Hold-to-Maturity-and-Fund-with-Deposits") Short-Term Funding Deposits Checking Accounts CDs Funding Bank Bank Debt Funding (Short and Long-Term Deposits Funding Depositors Deposits Real Money Accounts* Bank Client Funds *Asset Managers, Insurance Companies and Pension Funds Short- to Long-Term Cash Money Market "Portfolios" Checking Short- Account Term MMDAs Savings CDs Long-Term Investments Portfolios Bank Term Savings Ultimate Creditors Households, Businesses and the Rest of the World Discount Window Agency Debt Purchases Agency MBS Purchases Agency Debt Purchases ` Loan Collateral Reserves Agency Debt Reserves Agency MBS Reserves Agency Debt Reserves 11/25/ /25/ /25/2008 Federal Responses (Shadow Bank Backstops) Deposit Insurance (FDIC) FDIC Deposit Insurance Insurance Premia Federal Government No Implicit Explicit Insurance Fees GSEs, DoE, SBA No Implicit Explicit Insurance Fees Federal Government No Implicit Explicit Insurance Fees European Sovereign and Quasi-Sovereign States No Implicit Explicit Insurance Fees Public Risk Repositories Public Credit Transformation (Tail Risk Absorption) Public Risk Repositories (Tail Risk Absorption) Temporary MMMF Guarantee No MMMF Explicit Insurance Fees 9/18/2008 *Funded by UST's $50 billion Exchange Stabilization Fund PBGC Insurance Implicit Premia Insurance The "Cash" Shadow Banking System Deposit Insurance (FDIC) Liability Insurance (Federal Government) Credit Insurance (GSEs, DoE, SBA) Liability Insurance (Federal Government) Liability Insurance (EU Government) Insurance Guarantees Step (1): Loan Origination Step (2): Loan Warehousing Step (3): Issuance Step (4): Warehousing Step (5): CDO Issuance Step (6): "Intermediation" Off -Balance Sheet On -Balance Sheet Intermediation Intermediation Catalogue:, Shadow Bank Liabilities Step (7): Wholesale Funding (Shadow Bank "Depositors") Short-Term Debt Instruments Fannie and Freddie* CMOs Regulated Money Market Unregulated Money Market Direct Money Market Investors Ultimate Borrowers Ultimate Creditors Agency MBS (Time-Tranched Agency MBS) Agency Discount Notes Intermediaries Intermediaries Corporate Treasurers Agency A1 TBA Agency CMO Agency * Pass- Market MBS Tranches Bills CP Through $1 NAV Shares *Conforming mortgages RRs FH LBs Fannie and Freddie Federal Government Cash "Plus" Funds Other* Discount FFELP (Retained Portfolios) Liquidity Puts A1 *ARS, MMMFs Notes A1 Agency Discount Munis ARSs CP MBS Notes TOBs $1 NAV Agency * Private Agency or BDP Shares Debt Debt VRDOs RRs *Conforming student loans 2a-7 MMMFs Other* Bank Treasurers FHLBs A1 *ARS, MMMFs, as well as A1 SBA (Retained Portfolios) A1 () Tranches CP MTNs and term CP A1 Agency Discount $1 NAV $1 NAV BDP Shares * MBS Notes BDP Shares A1 Private Agency RRs RRs Short-Term Savings Debt Other* Enhanced Cash Funds Other* *Conforming SBA loans *TOBs and VRDOs A1 *ARS, MMMFs Money Market Portfolios CP Direct $1 NAV Investme Short- Term BDP Shares $1 NAV Savings RRs Shares "Prime" Homeowners Commercial Bank* Subprime, RMBS, CMBS Trading Books SIV, SIV-Lite CP Other* LGIPs Dollar Single-Seller Conduit A1 CP Offshore (non-2a-7) MMMFs *ARS, MMMFs, as well as A1 1st Lien Deposits Home Repos CP A1 MTNs and term CP LTD MTNs CP $1 NAV Repo High-Grade CDOs Supers CNs* $1 NAV BDP Shares Securities LTD Haircuts Supers *Capital Notes BDP Shares RRs Households O/C Multi-Seller Conduit* Broker-Dealer* High-Yield CLOs AA-A Asset Manager* RRs Ultra-Short Bond Funds Other* Households and Nonprofits Subprime Homeowners *FHC affiliate (Warehouse and Term) (LBO ) Repo Conduits Arbitrage Conduit Other* A1 *MMMFs A1 *TOBs and VRDOs CP Structuring Savings: 1st Lien Reverse Assets Home $1 NAV and Excess "" Repos* Mezzanine CDOs BDP Shares Syndication Cash 2nd Lien Supers RRs Finance Company* O/C O/C BBB O/C Other* Sweep Accounts CP Single-Seller Conduit *FHC affiliated *FHC affiliate Consumer *FHC affiliate *ARS, MMMFs, as well as A1 Consumers (Credit Card ) Hybrid Conduits Liquidity Puts* BDPs MTNs and term CP BDP A1 $1 NAV Goods Long- Short- & MTNs Term BDP Shares Term BDPs Services Munis Munis RRs O/C Other* Nonfinancial Corporates *FHC affiliate O/C *ARSs, TOBs, VRDOs *ARS, MMMFs Businesses Europe an Banks Federal Reserve SIV [ ] DW Invest- C&I CP Euro TAF ments Mezz Deposits FX Swaps LTD MTNs Tri-Party Repo System TSLF Supers CNs* Mezz Federal, State TSLF Nonfinancial Businesses Multi-Seller Conduit* Hybrid Conduits *Capital Notes CDO Tri-Party Clearing Banks* and Local Governments PDCF Businesses (Warehouse and Term) ( Warehouse Conduits) CPFF Cash lending Savings: TALF CRE Reverse AMLF Assets CRE Reserves for Excess "" Repos Collateral Bonds securities collateral Cash MMIFF ML, LLC O/C O/C Europe an Banks ML II, LLC Private *European bank affiliated Arbitrage Conduit [ ] *BoNY and JP Morgan Chase ML III, LLC Portfolio Companies LSAPs Euro Mezz Deposits LBO OMO Firms Mezz RoW Collateral O/C CDO (Foreign Central Banks) Off-Balance Sheet Off-Balance Sheet Off-Balance Sheet Off-Balance Sheet Off-Balance Sheet Off-Balance Sheet Off-Balance Sheet The GSEs' Credit Intermediation Process FHCs' Credit Intermediation Process European Banks' Shadow Banking Activites The Government-Sponsored Shadow Banking System (Public Originate-to-Distribute Model) The "Internal" Shadow Banking System (Private Originate-to-Distribute Model) Wholesale Funding (Short-Term Funding) Wholesale Funding (Overnight Funding) Savings: Excess "" Cash MMIFF Nonrepo Reserves MMS Savings: Local FX Currency Reserves Medium-Term Instruments Agent Securities Lending Federal Government RMBS Finance Company* (1st lien, private label) Credit Hedge Fund* MTNs Cash Reinvestment Accounts Tax Treasury CP Single-Seller Conduit A1 A1 Securities Lending* Revenues Bonds Private Repos CP BDP MTNs Cash Cash Securities MTNs High-Grade CDOs BDP Collateral Collateral Lent RoW Governments Supers *Broker-dealer affiliate Asset Manager, RRs (Sovereign Wealth Funds) State Governments O/C Broker-Dealer* Subprime AA-A Prime Broker Other* *Done by custodian banks Savings: *Broker-dealer affiliate (2nd lien, subprime, HELOCs) Trading Books Trading Book A2 & A3 () Tranches *MMMFs, MTNs, term and on an agent basis. Export "" Tax Tax State A1 TOBs and VRDOs Revenue Bonds Super Revenues Revenues Bonds Structuring Seniors and Repos Repos FX (A2-A3) Bonds* Syndication Mezzanine CDOs Super Principal Securities Lending Reserves Supers Seniors Industrial Loan Company* Haircuts BBB Cash Reinvestment Accounts *Issued to central banks Local Governments Broker Sweep Accounts *DBD affiliate CMBS and High-Yield CLOs *Broker-dealer affiliate A1 Securities Lending* in exchange for investibe FX Brokerage (LBO ) Liquidity Puts* Agency Debt* CP Long-Term Savings Brokered Tax Muni Brokered Clients' A1 Cash Cash Securities Deposits Long- Short- Revenues Bonds Deposits Cash Agency BDP Collateral Collateral Lent Fixed Income Portfolios* Balances Term Term Debt Munis Munis RRs Other* *Done by real money accounts Debt Term *Broker-dealer affiliate *ARSs, TOBs, VRDOs *Medium-term debt *MMMFs, MTNs, term and on a principal basis. Savings TOBs and VRDOs CNs *Bank, Shadow Bank and Corporate Debt Consumer Standalone Finance Company (Card, Auto, Student Loan) Credit Hedge Fund CP Single-Seller Conduit A1 Long-Term Instruments (LTD) Asset Managers* Repos Cash Long-Term Debt MTNs LTD Client MTNs Private Portfolios* Haircuts LTD Funds O/C Multi-Seller Conduit* Other Public Term Agency Structure ("Rent-a-Conduit") (Floorplan, Equipment, Fleets) LPFCs LTD d Credit Savings A1 CP *Mutual Funds, ETFs, Separate Accounts *Bank and Corporate Debt MTNs A4 and Tranches LTD CNs* Captive Finance Company Industrial Loan Company* O/C *Capital Notes (A4) CP *Independent conduit Middle-Market CLOs Pension Funds, Insurance Companies* Brokered ( to SMEs) REITs Cash BDP A1 MTNs ` Deposits Structured Credit Portfolios* MTN [ ] LTD Pension [ ] LTD CDOs Liabilities Debt HG Super Structure Tranches Term *Finance company affiliate Senior d Credit Savings Mezz Super *Public and Private Pension Funds, Tranches Senior and Life and P&C Insurance Companies *Term and CDO debt and equity tranches Off-Balance Sheet Off-Balance Sheet DBDs' Credit Intermediation Process Independent Specialists' Credit Intermediation Process The "External" Shadow Banking System (Independent Specialists: Originate-to-Fund Model DBDs: Originate-to-Distribute Model) Wholesale Funding (Medium-Term Funding) Wholesale Funding (Term Debt Funding) Credit Insurance (Mortgage Insurers) Credit Insurance (Monolines) Credit Insurance Credit Insurance Credit "References" Federal Responses (Shadow Bank Backstops) TLGP Debt MTNs Insurance Mortgage Insurers* Credit Premia Insurance *Unaffiliated with originators! Monoline Insurers* Credit Premia Insurance *Unaffiliated with originators! Diversified Insurance Co. Credit Premia Insurance *Unaffiliated with originators! Private Risk Repositories Private Credit Transformation (Tail Risk Absorption) Public Structured Credit and CDO Provision of Risk Capital Alternative Asset Managers* Cash MTNs LTD Client Funds *Hedge Funds and Private (only credit exposures) Credit Hedges CPFF TALF TSLF/Maiden Lane LLC Maiden Lane III LLC TAF FX Swaps TSLF/PDCF AMLF CP Wareho- CDS Tri-Party Reserves Reserves used Reserves on Reserves Reserves $ FX Reserves Reserves Collateral CDOs Maiden Lane II LLC Subprime Reserves 10/7/ /25/ /11/ /12/ /12/2007 3/11/08 and 3/16/08, respectively 9/19/ /21/2008 3/11/08 and 3/24/2008, respectively 11/10/2008 The "Synthetic" Shadow Banking System Counterparty Hedges Warehouse Hedges Counterparty Hedges Warehouse Hedges Warehouse and Counterparty Hedges Synthetic Credit Liabilities Single-Name and Index Corporate CDS CDPCs Hedgers* Ultimate Borrowers CPDOs* Short-Term Synthetic Liabilities Ultimate Creditors Unfunded, Portfolio Protection* Bond(s) CDS Protec- Protec- [ ] Funded tion Insured Term tion Sold and Protection Hedges Funded CDOs Assets Savings Protectio *Referencing corporate loan indices, etc. Households, Businesses, Governments Households, Businesses, Governments Single-Name and Index n Broker-Dealers* *Hedging Motives and the Rest of the World (RoW) Sovereign CDS Long-Term Synthetic Liabilities Broker-dealer CVA desks, pipeline hedges,, Protecnegative basis traders, real money accounts, etc. Protec- Funded Assets Bond(s) CDS Counterparty Hedges Warehouse Hedges tion Counterparty Hedges Warehouse Hedges Warehouse Hedges tion Sold and Protection Bonds Bought CDOs Credit Hedge Funds Speculators* Structured Credit and Loan Unfunded *Market Makers Funded Synthetic CDOs* Synthetic Exposures* CDS Indices Protec- (Credit-Linked Notes) Counterparty Risks* Protec- Unfunded Synthetic CDOs* tion, "Naked" Credit Term tion Sold Unfunded Bets Savings Loan(s) CDS Funded Positions [ ] Protec- and Protection Treasurys tion CDOs *Speculative Motives Referencing and single-name CDS *Referencing single-name CDS indices, etc. *Inability to meet Proprietary trading desks, credit hedge funds, etc. indices, etc. unfunded liabilities, etc. Source: Shadow Banking (Pozsar, Adrian, Ashcraft, Boesky (2010)) Private Risk Repositories The "Synthetic" Shadow Banking System (Derivatives-Based Risk Repositories) 14 Copyright 2012 Risk Economics, Inc.
15 Cross-Border Financial Surveillance: A Network Perspective (IMF Working Paper 105, April 2010 ) by Marco Espinosa-Vega and Juan Sole 15 Copyright 2012 Risk Economics, Inc.
16 A network analysis of global banking: (April 2011) by Camelia Minoiu and Javier A. Reyes 16 Copyright 2012 Risk Economics, Inc.
17 Does God Play With Fuzzy Dice? A stochastic game is a dynamic game played by one or more players with probabilistic transitions, such that at each stage the probability distribution for that new random state depends on the previous state and the actions chosen by the players Representation of a finite-state machine (example): an FSM that determines whether a binary number has an odd or even number of 0 s. FSM can be non-deterministic (i.e. stochastic). Also state machines can be infinite (i.e. continuous) What if certain parameters (e.g. transition states) are fuzzy, time-varying, etc.? Probabilistic parameters of a Hidden Markov model (example of the simplest dynamic Bayesian framework): x states, y possible observations; a state transition probabilities, b output probabilities Model underlying the Kalman filter. Squares represent matrices. Ellipses represent multivariate normal distributions (with the mean and covariance matrix enclosed). Unenclosed values are vectors. In the simple case, the various matrices are constant with time, and thus the subscripts are dropped, but the Kalman filter allows any of them to change each time step 0 17 Copyright 2012 Risk Economics, Inc.
18 Bayesian Graphical Models A Bayesian network is a probabilistic graphical model that represents a set of random variables and their conditional dependencies d via a directed d acyclic graph (DAG). Bayesian networks that model sequences of variables are called dynamic Bayesian networks. Generalized Bayesian networks that can represent and solve decision problems under uncertainty by combining probabilistic inference and utility maximization are called decision networks, relevance diagrams,, or influence diagrams. Efficienti algorithms exist that perform inference and learning in Bayesian networks. A Markov random field ( MRF ), Markov network or undirected graphical model: a graphical model in which a set of Markov random variables are described by an undirected graph, and is similar to a Bayesian network in its representation of dependencies. An MRF can represent certain dependencies that a Bayesian network cannot (such as cyclic dependencies), but cannot represent certain dependencies that a Bayesian network can (e.g. induced dependencies). The classic MRF is the Ising model a statistical model of ferromagnetism A log-linear model is a Markov random field with feature functions f k such that the full-joint distribution can be written as shown with partition function z, and where X is the set of possible assignments of values to all the network's random variables 18 Copyright 2012 Risk Economics, Inc.
19 Risk Economics, Inc. Risk Economics, Inc. (RiskEcon ) provides advisory services that apply rigorous analytics to large scale real world geopolitical and socio economic issues relating to demographics and macroeconomics. The firm s expertise includes domains within finance, regulation, political risk, commerce and consumer behavior, labor, housing, immigration, global population, resource allocation environment, health and aging. The RiskEcon litigation practice also provides advisory services and testimonial expertise on complex issues related to financial instrument valuation models and frameworks, market and industry standards and practices for the financing, risk management, active trading, and hedging of OTC derivatives and structured products. RiskEcon computational economics activities focus on the proprietary development and scalable implementation of robust modeling and data analytic frameworks, including the application of computational tools and methods derived from machine learning, data mining, and text mining to systemic real world issues. Our client roster and affiliations are diverse and include multinational corporations with interests in natural resources, commodities and energy, global insurance and reinsurance firms, multilateral institutions and government agencies, as well as leading law firms and global banking institutions.. 19 Copyright 2012 Risk Economics, Inc.
20 David K.A. Mordecai Risk Economics, Inc. 20 Copyright 2012 Risk Economics, Inc.